Daily Speculations

Simple predictions always work in practice better than complex ones. A recent exchange among traders and academics revealed some interesting facets of this insight that we are pleased to share here.

It started when Dr. Brett Steenbarger, author of The Psychology of Trading, found a timeless insight while shopping for a timepiece. "I found some very showy and expensive examples, some in gleaming stainless steel and gold, some in solid gold, some gold colored to look like 18k. The Breitling Superocean Professional was utterly unremarkable to the eye. It has a highly non-reflective, matte finish so that divers won't call attention to themselves among aggressive underwater predators. It's not made of gold, because gold cannot withstand 5,000 ft of pressure. No one notices the 3.7 mm thick crystal that withstands a ton of pressure, and no one catches the decompression valve on the side that vents the gases that accumulate in the case during long periods of immersion. To perform flawlessly and unobtrusively under great pressure...my new Breitling gives me a fine standard to strive for as a trader."

The value of simplicity is beautifully explained by Arnold Zeller, in Simplicity, Inference and Modelling : Keeping it Sophisticatedly Simple. Zellner defines simplicity as the number of terms, the powers, and the coefficients. And that's a good template for throwing out market systems also.

Zellner wrote us: Please note that the punch line is KISS, Keep It Sophisticatedly Simple, not as they say in industry, Keep It Simple Stupid, since some simple models are stupid. Also, note that the idea that simpler models will probably work  better in practice is a restatement of the "simplicity postulate" due to Jeffreys and Wrinch and believed by many scientists and others. Welcome aboard and KISS, it's fun.

Tim Rudderow adds: I reminded of an analysis of the junk market by my colleague Paul DeRosa.  A couple of years ago, he made the remark that the rate of default was beginning to slow and that low interest rates would improve corporate cash flow. He said,  "I think I am supposed to own junk here."  Seems like a simple analysis, when in fact it was the result of years of experience in the fixed income market.  A quote I love is, "The only simplicity to be trusted is the simplicity found on the far side of complexity."